Comparative analysis of investment assessment tools in finance

Finance

Different Investment Assessment Tools

Capital budgeting will require the ability to assess different types of investment. There are various tools which may be used to evaluate potential investments, each of which has advantages and disadvantages. The four main methods are net present value, possibility index, and internal rate of return and payback period. In order to assess how the tools may be utilized, and which may be most suitable for assessing and investment each of these four assessment tools will be reviewed.

Net Present Value

The net present value is an assessment tool which allows for the value of an investment to be assessed in today's money. The process involves taking the future net cash flows (revenue less expenses) and discounting them to allow for the time costs money (Bodie et al., 2010). The discount that is applied may be the expected rate of inflation, but more commonly it will be the weighted average cost of capital for the firm, as that will reflect the cost of the investment, and the opportunity cost (Bodie et al., 2010). The future cash flows will be discounted, and once the cash flows each is discounted an added together, there will be a deduction of the initial investment. If the resulting figure is more than zero, the investment will provide a positive return after allowing for the discount. If the figure is zero or less, the project is not providing the required return to cover for the cost of money.

The net present value is a popular tool, as it allows for different types of investment, for example those with different investments amounts, and over different periods, to be evaluated and compared using the same assessment tool (Bodie et al., 2010). The process also allows for some flexibility, as the discount factor may be changed or adapted in order to reflect any required risk premium where projects are investments may reflect a greater risk to the investor. However, there are also some disadvantages with this assessment tool. The assessment is based on projections, if there are any divergences from those projections there can be a significantly different outcome. The net present value also has an inherent bias towards projects which provide higher short-term returns, due to the compounding effect of the discount applied to returns in later years. The use of NPV may also be difficult as the result is a dollar value, which can create ambiguity when comparing very different types of projects, especially where there is a significantly different investment amount.

Internal Rate of Return